Prudential Asset Allocation

Few days back, this tweet by Muthukrishnan caught my eye.

Had a long chat with a SME client last evening. He is temporarily shutting down his business as he has one year receivables pending.

He says his clients are honest but are in genuine distress. He is stopping SIPs today. Going to live on emergency fund which would last a year.— D.Muthukrishnan (@dmuthuk) August 21, 2019

While I have used the tweet of @muthuk, my views below are not with respect to him. I believe there are hundreds of such examples but not highlighted.

A genuine advisor starts investment counselling process by concentrating on the asset allocation mix. These days, the only advisors one hears about is those who start off by recommending what they believe is the best fund to invest in.

Asset Allocation is the foundation on which you build the structure. In good times, read as when markets are bullish, advisors would rather first build the structure and only then think about if any foundation is required.

Asset Allocation is personal – my allocation mix is suitable to me only. It’s not possible for others to coat tail or just copy. Being personal unfortunately works against for when we don’t even disclose all the details to our Doctor, providing our financial position to an adviser is an unknown concept.

This has meant that the advisor is working with data that is not full and hence liable to make mistakes. Assume for instance a client walks in and says that he wishes to invest in Equity, a distributor with little or no data on his other assets can only provide him a list of funds he believes are good investments.

As an analogy, think about going to a Chemist shop and asking for tablet for fever. In all likelihood, he would disburse you with a strip of paracetamol. But what if you are experiencing fever accompanied by shivers. That would require a different approach since shivers come for specific reasons that paracetamol alone won’t help.

In India, main stay for Mutual funds are distributors who are by SEBI disallowed from advising on asset allocation. They can only give incidental advice and this is restricted to selecting MF schemes for investment. In other words, they are more of a Chemist than a Doctor who can diagnose the issue properly and provide the treatment necessary.

If you are not invested in equities, its seen as if you are missing out. Fear of Missing Out happens even more in bull markets, but not everyone requires equity exposure in the first place. Let me take a couple of examples where you maybe better off with Debt than Equity.

If you are a business owner, you are already upto your neck in equity – just that its your own firm’s equity that is most of the time pretty illiquid. Business fail all the time and while I don’t have data, I think there is a very high correlation between failure and the state of the economy.

When things are good, your investments are good, your business is good, life is great. When things turn rough in the market, market goes down, your business goes down and your life suddenly sees a different trajectory.

Being a Chemist and Druggist is a wonderful business. It comes with certain moats that have made it tough to disrupt in the way other businesses have been disrupted. Yet, disruption is always round the corner for who knows what the future holds. 

A chemist I know has invested in savings in buying a commercial complex that yields a sizeable rent. This has ensured that even if tomorrow his business is somehow disrupted, his life can go on as usual thanks to the continuous cash flow.

In other words, he has invested in what can be compared to Dividend Yielding stocks that may not give much capital appreciation, but can provide good cash flows over time. While Real Estate is looked negatively from the angle of asset allocation for being a dead asset, for him this is as good as equity with only draw-back being it is illiquid in nature.

Buying a house these days invariably means taking a loan with monthly EMI’s eating substantially into ones earnings. Thanks to the tax treatment, it may seem to make sense to take loans these days than save and pay by cash. Yet, how do you treat the loan has large implications when times are bad.

The biggest fear than most young employees express is the risk of layoff’s since many are burdened with staggering amount of loans – from Mobile Phone to Cars to Homes and what not. 

In 2006 / 2007, Americans had bought homes on loans. While the focus for long has been about loans offered to people who had no credit history or even ability to pay back, a lot of loans were also to people with steady jobs.

When the financial crisis erupted, it not only brought down housing prices but also meant loss of jobs. Take a look at the change in Unemployed Rates during that period

If one was invested in addition in equities, he saw his portfolio cut by 50%. Its easy to ridicule those who sold equities near the bottom, but if one had lost his job and his house at risk of being possessed for not making the monthly payment, better something than losing everything.

A friend of mine was recently asking about how he should treat his house in his asset allocation mix. Thinking on the same, I believe that if there is a loan repayable, you are better off treating it as equity than as fixed asset which is what it is.

Advisors to Fund Managers use the Warren Buffett quote 

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

While we can summarize the quote as one about how long term is rewarding in equities, another way of looking at is that if you need money over the next 10 years, equities may not be the best bet.

That doesn’t mean that you need to have zero exposure to equities, but given the fact that India is one of the few countries where you can get real positive returns on Debt, its unwise to load up on Equities if the objective of the investment is to help you in times of distress.

Have a prudent asset allocation plan that plans for worst case scenarios. Debt while not seeming sexy as equities can actually deliver better results if you face volatility in your career.

Assets can be temporary, Liabilities are permanent. Stress test your allocation to ensure that a quotation loss doesn’t become a permanent loss. As a quote goes,

A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain. 

You don’t want to be without an umbrella when it starts to rain.